Bernanke: Fed is probing flawed foreclosure process and its risks for economy

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America’s tide of foreclosures has been overshadowed, for now, by something even more perplexing: uncertainty about whether proper legal practices have been followed when homes pass from one owner to another.

Ben Bernanke, the chairman of the Federal Reserve, said regulators from the Fed and other agencies are “looking intensively” to see if “improper foreclosures” are occurring. Preliminary findings from the investigation could come in a month, Mr. Bernanke said in a speech Monday.

The Fed is considering not just the scope of paperwork problems but also their implications for the economy, including “the potential effects of these problems on the real estate market and financial institutions,” Bernanke said.

Public concerns have been rising since Sept. 17, when GMAC’s mortgage division said it needed to temporarily suspend foreclosure activities in 23 states because of potential flaws in documentation. Some other loan servicers followed suit, and all 50 state attorneys general called for an investigation. Federal agencies have launched their own probes.

On the surface, this new mortgage mess is about loan servicers who may have cut corners in the rush to file a record number of foreclosures. The symptoms, uncovered in lawsuits, include “robo-signing” of affidavits (attesting to information without checking that it’s true) and signing key papers without a notary present.

But the larger worry is that paperwork flaws may exist not only in the foreclosure process but also in other real estate transactions, casting into doubt whether the purported mortgagee (creditor) really has authority to foreclose.

“Although the ‘robo-signer’ issue has been grabbing headlines lately, the real problem is the possibility of breaches in the various transfers of a mortgage and its attached note during the securitization process,” says bank-industry analyst Paul Miller, in a recent report he wrote with colleagues at FBR Capital Markets. “If one of these hand-offs is done improperly, then the mortgage’s chain of title could be called into question.”

Some banking analysts, including Mr. Miller, predict that the dust-up over documents will subside relatively soon. A three-month delay in foreclosures, he reckons, would cost the banking industry about $6 billion, with another $3 billion or so in costs of litigation over allegations of paperwork flaws.

Already, on Oct. 18, Bank of America and GMAC (part of Ally Financial) said they had found no major flaws in their processes and were resuming foreclosure actions in many states.

But their moves don’t guarantee that the controversy will be short-lived. In a more troubling scenario, botched paperwork could have wider ripple effects that harm the economy.

New foreclosures could be halted for six to 12 months, and legions of old foreclosure cases could be reopened for judicial review. Mortgage investors could ramp up lawsuits against banks to cover their losses, due to clerical lapses when the loans were securitized. Even sales of nondistressed properties could suffer, if home buyers don’t trust the system by which property rights were transferred in the past.

Easy or not, steps to restore trust are needed, finance experts say. It’s not clear what those steps will be, but one option is through the judicial process, as courts in various states rule on key issues. Also, Congress could try to intervene, although that wouldn’t be easy in the period just before or after the November elections.

Even with legal battles, housing experts expect the foreclosures trend to resume at some point.

Americans are divided over whether the foreclosure wave should be allowed to run its course, according to a Christian Science Monitor/TIPP poll conducted in early October.

More than one-third say “let market forces and the banks work it out.” Some 46 percent would support efforts by the federal government to require more lenders to revise the terms of mortgages. Another 14 percent say the government “should step in and begin refinancing distressed mortgages itself.”

The economy’s problems can be blamed on a number of things, but Americans see foreclosures as a key factor. Some 83 percent say that foreclosures are having at least some negative effect on the nation’s economic recovery.

At a Fed-sponsored conference Monday, some housing experts said new efforts to prevent foreclosures are needed, despite a month-over-month rise in home-sale volume.